Monti will resign once the 2013 budget has been passed,
bringing forward an election and causing some to sell their
bonds, anticipating a drawn-out political tussle that could
undermine Italy's commitment to austerity.

"This came really as a blow to the market. Everyone was
prepared to head into year-end with a benign environment of low
yields and volatility and good liquidity," said Michael Leister,
senior strategist at Commerzbank in London.

The return to frontline politics of former Prime Minister
Silvio Berlusconi, anathema to many investors, also knocked
confidence. On Tuesday, Berlusconi accused Monti of pursuing
German-centric policies -- comments that point to a bitter
election campaign fought over European issue.

Italian 10-year bond yields were 4.6 basis
points up on the day at 4.86 percent, having risen by 27 basis
points in the previous session. The Spanish equivalent, which
suffered along with Italy on Monday, was steady at 5.58 percent.

Market participants were expecting increased volatility over
the coming months and even though some saw any selloff as a
chance to redouble longer-term bets on lower yields, a return to
the two-year lows seen last week was unlikely.

"In Italy for now we have seen the lows in yields this year
and with supply looming on Thursday we believe there is further
upside pressure on the cards," Leister said.

Italy will sell new three-year debt alongside an existing
2026 bond at an auction on Thursday, planning to raise up to
4.25 billion euros.

FED WATCHING

German Bund futures were 10 ticks higher at 145.70
with traders not expecting significant price swings or trading
activity before the outcome of the U.S. Federal Reserve's
two-day policy meeting starting later in the session.

A Reuters poll showed the Fed is expected to announce that
it will extend its asset purchase scheme and commit to buy $45
billion of U.S. debt per month, helping to keep yields low on
closely-correlated German Bunds.

"The market will be severely disappointed if we don't get
fresh purchases now. You'd feel that outcome is in the price,
there's now more risk that they don't do anything and we get
disappointment," a trader said.

"Bunds will be sensitive to that, particularly given the
rally we've had back to the low end of the yield range."

German 10-year yields were 0.9 bps lower on
the day at 1.291 percent, toward the lower end of the range
defined during the second half of the year by July's low of
1.126 percent and September's high of 1.702 percent.